The Mutual Fund Crisis – Past, Present and Future Exposures to the Professional Liability Insurance Market

Market Timing and Late Trading What Generally Occurred Regulatory investigations revealed there was a cottage industry catering to:  Market Timing The practice of short term buying and selling of mutual fund shares in order to exploit inefficiencies in mutual fund pricing  Late Trading Shares in mutual funds are purchased after hours at the share price at the close of the stock market with knowledge of post-closing events which may impact the share price at the next day's opening of the market  Result Increase trading costs, lower returns, and an adverse impact for long-term investors

Consequences of Mutual Funds allowing Market Timing and Late Trading  Regulatory Actions and Settlements  Reforms and changes to fees and other industry practices  Displacement of business and executives  Private Class Actions by fund-holders  Private Class Actions by parent company shareholders

Regulatory Settlements  To date, regulatory settlements have grown to a total of $2.918 billion, consisting of: $925 million in future fee concessions $1.993 billion in restitution and penalty assessments earmarked for payment to mutual fund-holders who incurred loss through late trading or market timing

Regulatory Settlements (millions)

Regulatory Settlements (by type)

Regulatory Settlements (penalty v. restitution)  Penalty relative to restitution, where available. (Bad actor indicator?)  Penalties, in addition to restitution funds, are earmarked under Sarbox 308/SEC Rule 1100 to be paid to “investors who were harmed by the violation.”

SEC Alliance Order of 12/18/03 “Disgorgement” required  Provides that in the event investor losses exceed funds paid, Alliance agreed to top off to allow for “full satisfaction.”  “In the event that full satisfaction of item (i) would require a payment of more than $200 million, Alliance Capital agrees that it will increase the disgorgement portion of its payment obligation by [that] amount.”

SEC Putnam Order 11/13/03 “Restitution” required  Putnam order required that “Independent Assessment Consultant shall calculate the monetary amount necessary to fairly compensate Putnam funds’ shareholders for losses attributable to excessive short- term trading and market timing trading activity”  Subsequent calculation yielded $10 million result.

SEC MFS Order 2/5/04 – “Disgorgement” required  Independent Distribution Consultant was to develop a plan “to compensate fairly and proportionately the funds shareholders for losses attributable to late trading and market timing trading activity...”  Order also provides that the Plan “shall provide for fund investors to receive, in order of priority, (i) their aliquot share of losses suffered by the fund due to late trading and market timing activity, and (ii) a proportionate share of advisory fees paid by such fund during the period of such late trading.”

Penalty Offset Provision  E.g., Invesco - “To preserve the deterrent effect of the civil penalties, Respondents... agree that they shall not, after offset or reduction in any Related Investor Action based on Respondent’s payment of disgorgement in this action, further benefit by offset or reduction of any part of Respondents payment of civil penalties in this action (“Penalty Offset”). If the court in any Related Civil Action grants such Penalty Offset, Respondents agree that they shall... pay the amount of the Penalty Offset to the US Treasury. Such a payment shall not be deemed an additional civil penalty... ”

Industry Developments  Fees  1800 funds have lowered fees over the last year (aside from the regulatory settlements)  Reforms and changes to industry practices  Compliance Officer – funds must have compliance chiefs who report to the board  Board composition – chairman and at least 75% of the board must be independent  Directed brokerage – steering fund’s trading business to brokers who promote the funds is prohibited  Additional disclosure requirements

Industry Developments  Displacement of well-known executives  Lawrence Lasser (Putnam)  Harold Baxter, Gary Pilgrim (Pilgrim Baxter)  Richard Strong (Strong Financial)  Winning v. Losing Fund families  Janus – net withdrawals of $10 billion through July 2004  MFS - net withdrawals of $4.2 billion through July 2004  Fidelity Investments – net increase of $14.1 billion (v. $7.4)  Vanguard – net increase of $29.2 billion (v. $13)

Private Class Actions – Putative Classes  Class (Direct) Plaintiffs Mutual Fund Purchasers Mutual Fund Shareholders  Derivative Plaintiffs Mutual Fund Shareholders Parent of Fund Family Shareholders

Universe of Parties  Plaintiffs Putative Classes  Defendants Fund Family Entities (includes Trustees and Parent) Market Timers/Late Traders Brokers/other facilitators Trusts/other Clearing Platforms Third Party Financiers of Timing/Late Trading activity

Claims Asserted  Basic facts -- Funds increased assets under management by: Entering into undisclosed agreements with select customers and/or brokers (or other intermediaries) to permit Market Timing and/or Late Trading Otherwise permitting Market Timing and/or Late Trading activity in the Funds  Alleged Benefits to Fund Family Defendants Increased asset base increases revenues by upping management/advisory fees “Sticky assets” - generate fees, increase asset base and must remain static – a quid pro quo for allowing Timing and/or Late Trading

Claims Asserted (cont’d)  Misrepresentations/Omissions in Prospectuses Funds’ prospectuses contain disclosure of fund policy to prohibit/discourage excessive/abusive trading  may/will reject if exceed X trades/year  may/will impose redemption fees if exceed X trades/year Funds were portrayed as long-term (e.g. retirement) investments Market Timing/Late Trading was activity not disclosed to ordinary investors

Alleged Harm to Plaintiffs  Dilution of profits to long term holders because Timers entered Funds when they predicted a profitable event  Losses disproportionately fall on long- term holders because Timers got out of the market before a predicted loss would hit the Funds  Forced sale of Fund assets at inopportune times due to Timer activity Often en masse redemptions due to similarity of Timers’ models

Alleged Harm to Plaintiffs (cont’d)  Increased costs created by Timer trading Possible taxable capital gains Increased transaction costs  Disparate treatment (e.g., waiver of redemption fees/frequency of exchanges and redemptions)  Questions about harm to Fund holders, especially if timers lost money

Securities (1933) Act Claims  Section 11  Section 12(a)(2) Recessionary remedy  Section 15 Control person liability against fund advisors, trustees, parents and individuals

Exchange (1934) Act Claims  Section 10(b) Rule 10b-5(a) & (c)  Deceptive course of conduct/fraudulent scheme Rule 10b-5(b)  Untrue statement of fact/material omission  Section 20(a) Control person liability against fund advisors, trustees, parents and individuals

Investment Company Act of 1940 Claims  Section 34(a) Prohibits false prospectus statements and material omissions No express private right of action  Section 36(a) Action against directors, officers and advisors for breach of fiduciary duty No express private right of action  Section 36(b) Also a breach of duty claim Express private right of action  Section 48 Allows for Control Person liability

State Law/Other Claims  Breach of Fiduciary Duty/Constructive Fraud  Aiding and Abetting Breach of Fiduciary Duty  Unjust Enrichment

Status of MDL Proceedings  February 20, MDL Panel Transfer Order  Organization of Plaintiffs’ counsel / Lead Plaintiff issues:  Cases consolidated, by Fund Family, before 4 Judges in the District of Maryland  Consolidated Complaints filed on September 29, 2004

Multidistrict Litigation  Judge J. Frederick Motz, overseeing the consolidated actions: “Nobody should expect to get rich off this case... If there is any recovery, the great bulk of the recovery should go to those injured, not to their lawyers, particularly in light of the fact that so much of the underlying investigative work has already been done by public authorities.”

Multidistrict Litigation  Issue to be briefed – Whether the regulatory settlements will be offset against the potential damages in the private class actions lawsuits?

Professional Liability Coverage  Regulatory settlements specifically bar recovery of arguably both restitution and penalties  Definition of “Loss?”  Defense Expenses (which have been reported running $2+ million per month on some of the noted insureds)  Vigilant Ins. Co. v. Credit Suisse First Boston Corporation applicable?  Expenses to administer?

Prohibition of insurance recovery  Settlement template by SEC and NYAG stipulate that the fund families will not seek insurance reimbursement for the disgorgement component of their regulatory settlements (Spitzer initiative; followed by the SEC).  Defense Expenses – no prohibition in the settlement agreements  Vigilant Ins. Co. v. Credit Suisse First Boston Corporation applicable?

Next Wave of Claims?  Conflicted promotion of proprietary funds  Directed brokerage of trading commissions  Soft dollar commissions arrangements with brokers  Excessive fees  Failure to pay breakpoint discounts